Finite-sample critical values of the AugmentedDickey-Fuller statistic: The role of lag order

Transcription

1 Finite-sample critical values of the AugmentedDickey-Fuller statistic: The role of lag order Abstract The lag order dependence of nite-sample Augmented Dickey-Fuller (ADF) critical values is examined. Theoretical and empirical results show the failure to incorporate lag order e ects increases the nonstationarity bias associated with the ADF test. Keywords: ADF test; unit root; critical values; lag order. JEL codes: C15; C22. 1

2 1 Introduction Despite being based upon the estimation of the (non-augmented) Dickey- Fuller (DF) (1979) statistic, the response surfaces of MacKinnon (MK) (1991) are routinely employed to calculate critical values for the Augmented Dickey- Fuller (ADF) statistic. Apotential problemtherefore existsasalthoughthe degree of augmentation, orlag order, of the test isasymptotically irrelevant it may a ect nite-sample critical values. Recognition of this led Cheung and Lai (CL) (1995) to derive response surfaces where critical values are a function of both sample size and lag order. 1 Given the superior t of these extended response surfaces it is surprising that the results of CL have not received widespread adoption nor have beenfully compared withthe results of MK. Whether lag adjusted critical values are signi cantly di erent to those of MK and whether this has implications for inference are the focus of this note. In the following section the alternative response surface formulations of MK and CL are presented. Section [3] examines CL and MKcritical values overa range of sample sizes and lag orders. Section [4] provides an empirical application using the U.S. money stock. Section [5] concludes. 2 Response surface speci cations The response surfaces of MK allow the calculation of DF critical values for any sample size. Using estimated values of the parameters f 1; 1; 2g, critical values,cv( ), are derived from the response surface: cv(t; )= 1+ 1T 1 + 2T 2 +" T (1) wheret is the sample size, is the level of signi cance, and" T is the error term. As T! 1 the functions of T tend to zero, leaving the asymptotic critical value 1: Despite the apparent exibility a orded by (1), it is based upon the estimation of a DF test rather than the typically employed ADF test. Although asymptotically irrelevant, nite-sample ADF critical values may be subject to lag order dependence. This has been noted by CL who derive more general response surface speci cations incorporating terms involving lag order(p) as given below: cv(t;p; )= 1+ 1T 1 + 2T 2 +Á 1 µ p T +Á 2 µ p T 2+"T;p (2) where" T;p is an error term. As with (1), the above speci cation was selected to ensure that ast! 1 an asymptotic critical value( 1) is approached. 2

3 There are some important features to note concerning (2). First, as the values of the parameters f ig and f ig di er, an evaluation of the impact of lag order e ects requires a direct comparison of (1) and (2) rather than just a calculation of the sum n Á 1 (p=t)+á 2 (p=t) 2o. Secondly, the parameters fá i g are of opposite sign, with Á 1 > 0; Á 2 < 0. This implies a possible cancelling e ect between the lag order terms in (2). Despite CL graphically presenting critical values for their response surfaces across a range of lag orders, sample sizes and signi cance levels, the comparison betweentheircritical values and those of MKwaslimited, with only critical valuesforp= 6 and T = 50;100 examined. The impact of lag adjustment on ADF critical values warrants a more thorough examination as CL found lag order regressors to be highly signi cant, with a range of criteria nding (2) to be a better tting speci cation than the commonly usedrestrictedformof (1). 3 Numerical examples In this section the critical values for the constant and trend ADF test 2 will be calculated for the following lag orders(p), sample sizes(t) and signi cance levels( ): p = f2;4;6;8;10;12;14g T = f80;100;120;150;200;500g = f0:01;0:05;0:1g The critical valuesderivedfrom this analysisare presentedin Tables One to Three. Two features to note fromthese results are: ² For all sample sizes (includingt = 1) and at all levels of signi cance, the MK critical values are greater in absolute value than those of CL. Consequently the MK values further exaggerate the low power problem associated with ADF tests. ² For any given sample size the MK and CL critical values diverge as the lag order is increased. This is observed at all levels of signi cance and persists when the sample size is increased. Therefore the possible cancelling out e ect due to the opposite signs of Á 1 and Á 2 does not occur. Tables One, Two and Three about here 3

4 The results show lag order e ects to substantially alter nite-sample ADF critical values, especially for larger values ofp. This is particularly relevant as recent studies suggest larger values of p should be applied in practice. First, De Jong et al. (1992) argue that the loss of power associated with larger values of p is outweighed by the size distortion resulting from the use of lower values. 3 Secondly, studies such as Choi and Chung (1995) and Ng (1995) show the use of higher frequency data to increase the power of ADF test. As the lag order of the ADF test typically increases with the frequency of observation, thispromotesthe use of highervaluesof p inempirical research. Lag adjustment of the critical values is therefore particularly signi cant when using high frequency data over a short span. 4 An empirical application To highlight the signi cance of lag adjustment, the critical values of MK and CL are applied to examine whether the M3 de nition of the U.S. money stock possesses a unit root. The data selected are seasonally adjusted, monthly observations from May 1967 to April 1986 obtained from the Federal Reserve Bank of St. Louis. The results of applying a constant and trend ADF test are presented in Table Four. Given the frequency of the data examined, lag lengths of 11 to 13 periods are considered. 4 To ease interpretation of the resultspresented and allow the MK critical values to remain xed, a consistent sample size was employed throughout by omitting an initial observation as the lag order decreased. Examining the results for p = f11;12;13g, the MK critical values fail to reject the unit root null hypothesis. Conversely, CL critical values reject the null forp = 11;13, although not forp = 12. The alternative critical values therefore provide con icting results, illustrating the non-stationarity bias present in the greater (absolute) values provided by the MK response surface. Table Four about here 5 Conclusion The lag order dependence of nite-sample ADF critical values has been considered via a comparison of the alternative response surfaces of MK (1991) and CL (1995). The theoretical and empirical results presented have shown the widespread practice of failing to incorporate lag order e ects to signi - 4

5 cantly reinforce the non-stationarity bias of the ADF test, particularly when examining high frequency data over short spans. References [1] Cheung, L.-W. and Lai, K.S. (1995) Lag order and critical values of the Augmented Dickey-Fuller test, Journal of Business andeconomic Statistics, 13, [2] Choi, I. and Chung, B. (1995) Sampling frequency and the power of tests for a unit root: a simulation study, Economics Letters, 49, [3] DeJong, D., Nankervis, J., Savin, G. and Whiteman, C. (1992) The power problems of unit root tests for time series with autoregressive errors, Journal of Econometrics, 53, [4] Dickey, D. and Fuller, W. (1979) Distribution of the estimators for autoregressive time series with a unit root, Journal of the American Statistical Association, 74, [5] Engle, R.F. and Granger, C.W.J. (1987) Cointegration and error correction: representation, estimation and testing, Econometrica, 55, [6] Hendry, D.F.and Doornik, J.A. (1996) Empiricaleconometric modelling using PcGive 9.0 for Windows, London: International Thomson Business Press. [7] MacKinnon, J. (1991) Critical values for cointegration tests, in Engle,R.F.and Granger, C.W.J. (eds) Long Run Economic Relationships, Oxford: OxfordUniversity Press. [8] Ng, S. (1995) Testing for unit roots in ow data sampled at di erent frequencies, Economics Letters, 47, [9] Ng, S. and Perron, P. (1995) Unit root tests in ARMA models with data-dependent methodsforthe selection of the truncationlag, Journal of the American Statistical Association, 90, [10] Schwert,G. (1989) Tests forunit roots: a Monte Carlo investigation, Journal of Business and Economic Statistics, 7,

6 Endnotes 1. The results of CL relate solely to testing for a unit root, whereas MK also provides critical values for Engle-Granger (1987) two-step tests of cointegration. 2. The constant and trend ADF test is the focus of the present note as this been suggested by CL (1995, p.280) to be the case where critical values are most sensitive to lag order and is also the form applied when analysing trending macroeconomic time series. 3. The size-power trade-o when considering low and high values of p has led to a large literature on the optimal lag order for ADF tests. Ng and Perron (1995) present and discuss a range of alternative decision rules. 4. Lag lengths basedupon data frequency are commonly appliedinempirical research. This is re ected in the default ADF lag orders of various software packages. An example, the default lag lengths of Pc-Give (see Hendry and Doornik, 1996) are 2 forannual data,5 forquarterly data and 13 for monthly data. The choice of lag lengths considered here therefore matches typical empirical practice, if not the previously referred to optimal lag length literature. Note also that although the values considered appear to be high, the Schwert (1989) criterion suggests a value ofp=15. 6

7 Table One ADF critical values: =0:1 Sample size (T ) MK 3:159 3:153 3:149 3:144 3:140 3:133 3:128 Cheung & Lai p=2 3:138 3:134 3:132 3:130 3:128 3:124 3:122 p=4 3:117 3:117 3:118 3:118 3:119 3:121 3:122 p=6 3:097 3:101 3:104 3:107 3:110 3:117 3:122 p=8 3:077 3:085 3:090 3:096 3:102 3:113 3:122 p=10 3:059 3:069 3:077 3:085 3:093 3:110 3:122 p=12 3:042 3:055 3:064 3:074 3:085 3:106 3:122 p=14 3:026 3:041 3:052 3:064 3:077 3:103 3:122 7

8 Table Two ADF critical values: =0:05 Sample size (T ) MK 3:466 3:455 3:448 3:440 3:433 3:421 3:413 Cheung & Lai p=2 3:439 3:431 3:426 3:422 3:417 3:410 3:406 p=4 3:416 3:412 3:410 3:409 3:408 3:406 3:406 p=6 3:395 3:395 3:395 3:396 3:398 3:402 3:406 p=8 3:376 3:379 3:381 3:385 3:389 3:398 3:406 p=10 3:359 3:364 3:368 3:374 3:380 3:395 3:406 p=12 3:344 3:350 3:356 3:363 3:372 3:391 3:406 p=14 3:330 3:337 3:344 3:353 3:363 3:387 3:406 8

9 Table Three ADF critical values: =0:01 Sample size (T ) MK 4:076 4:052 4:037 4:022 4:007 3:981 3:964 Cheung & Lai p=2 4:037 4:018 4:006 3:995 3:985 3:968 3:958 p=4 4:011 3:996 3:987 3:980 3:973 3:963 3:958 p=6 3:989 3:977 3:970 3:965 3:961 3:958 3:958 p=8 3:972 3:961 3:956 3:952 3:951 3:953 3:958 p=10 3:960 3:948 3:943 3:941 3:941 3:948 3:958 p=12 3:953 3:938 3:932 3:930 3:932 3:944 3:958 p=14 3:950 3:931 3:924 3:921 3:923 3:939 3:958 9

10 Table Four ADF(p) tests of U.S. M3 p ADF(p) Cheung & Lai( =0:05) MK( =0:05) 13 3:402 3:369 3: :287 3:373 3: :380 3:377 3:432 denotes signi cance using Cheung & Lai critical values. 10